Download a) Home`s demand curve for wheat is D=100

Answer Keys to HW1
Problem 1
Welfare analysis of tariff
International Economics
(answers keys are on the second page)
a)
Home’s demand curve for wheat is D=100-20P, supply curve is S=20+20P. Derive
Home’s import demand. What would be the price of wheat in the absence of trade?
b)
Now Foreign country’s demand curve is D*=80-20P, supply curve is S*=40+20P.
Derive Foreign’s export supply curve. What would be the price of wheat in the
absence of trade?
c)
Now allow Foreign and Home to trade with each other, at zero transportation cost.
What’s equilibrium price under free trade? What’s the world price? What’s the
volume of trade?
d)
Now Home imposes a specific tariff of 0.5 on wheat imports, i.e. t=0.5. What’s the
new price of wheat in each country, the quantity of wheat supplied and demanded in
each country, and what’s the new volume of trade?
e)
Now with all the results you’ve gotten so far, draw a graph similar to Figure 8-9 on
page 190 in your textbook. Calculate consumer loss, producer gain and government
revenue of Home country. What’s the net welfare of tariff of Home in this case?
Problem 2
The following questions are related to the issue of trade and inequality.
The US imports huge amount of goods from China each year. Because labor cost in China is
much cheaper (10% of US level according 2009 estimate), those imported goods tend to drive
down the price of similar products in the US. Let’s assume the US has two sectors: high-tech
and low-tech, the latter of which is in direct competition with China.
a) What is the impact of China’s imports on relative wages between the two sectors in
the US? Explain within the context of Stolper-Samuelson (SS) theorem.
Answer: China’s exports will drive down the price of low-tech goods in the US.
According to Stolper-Samuelson theorem, this increase of relative price of hightech goods will increase the relative return of high-skilled labor, which is used
more intensively in the high-tech sector. The return of the high-skilled labor is
just the wage they earn. So cheap Chinese exports will bring an increase of
relative wage of high-skilled workers vs. low-skilled workers, thus increasing the
income inequality between the two groups.
b) If you were a top US policy maker and your goal is to keep US manufacturing
industry strong so that it continues to provide job opportunities for the blue-collar
workers. Meanwhile, you don’t want to resort protectionist measures, which could
potentially invoke a trade war with China and hurt consumers at home. What would
be your policy proposition to President of the United States?
Answer: Although China has low-cost advantage, but the US can offset the costadvantage by increasing labor productivity. So a sensible policy recommendation
would be to provide incentives for firms to invest in low-skilled industries in so
that firms can increase capital investment relative to labor, or (K/L) capital labor
ratio, e.g., by buying smart machines. This way, blue-collar jobs will stay at
home and due to higher labor productivity, these workers will be paid higher
wage, shrinking the gap with the high-skilled workers.
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Answer Keys to HW1
International Economics
Answers to Problems 1
a. The import demand equation, MD, is derived from subtracting the home supply equation
from the home demand equation. This results in MD = 80 − 40 × P. Without trade,
domestic prices and quantities adjust such that import demand is zero, or MD=0. Thus,
the price in the absence of trade is 2.
b. Foreign’s export supply curve, XS=S*-D*, so XS = −40 + 40 × P. In the absence of trade,
XS=0 and the price is 1.
c. When trade occurs, export supply is equal to import demand, XS = MD. Thus, using the
results from a and b, we have P = 1.50, and the volume of trade is 20.
d. The new MD curve is 80 − 40 × (P + t) where t is the specific tariff rate, equal to 0.5.
(Note: In solving these problems, you should be careful about whether a specific
tariff or ad valorem tariff is imposed. With an ad valorem tariff, the MD equation
would be expressed as MD = 80 − 40 × (1 + t)P.)
The equation for the export supply curve XS by the foreign country is unchanged.
Solving again for MD=XS, we find that the world price is $1.25, and thus the internal
price at home is $1.75 (=1.25+t). The volume of trade has been reduced to 10, and the
total demand for wheat at home has fallen to 65 (from the free trade level of 70). The
total demand for wheat in Foreign has gone up from 50 to 55.
e. The welfare of the home country is best studied using the combined numerical and
graphical solutions presented below.
(note: the number 60 on the x-axis should be 65)
where the areas in the figure are:
a. 55(1.75 − 1.50) −0.5(55 − 50)(1.75 − 1.50) = 13.125
b. (1/2)(55 − 50)(1.75 − 1.50) = 0.625
c. (65 − 55)(1.75 − 1.50) = 2.50
d. (1/2)(70 − 65)(1.75 − 1.50) = 0.625
e. (65 − 55)(1.50 − 1.25) = 2.50
Consumer surplus change: −(a + b + c + d) = −16.875. Producer surplus change: a =
13.125. Government revenue change: c + e = 5. So net welfare change =
−16.875+13.125+5 = 1.25>0. In this case, home country’s term of trade gain, e, is
bigger than deadweight loss (b+d), so we have a gain on net welfare.
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